11 September 2014

Notes on ECB’s Comprehensive Bank Assessment (Part 5)

I haven’t been writing a piece for a while as my life has been quite a roller coaster in the meantime. However, a recent call from a reporter for the New York Times reminded me that independent views about the ECB’s Comprehensive Bank Assessment are still sought. So, as promised in the last update on the issue (Part 4 of this series), in this post I’ll elaborate on the baseline and adverse scenarios of the stress test. 

The scenarios were published on the EBA’s website a while ago, on 29 April 2014 to be precise. When compared to the winter 2014 forecast by the European Commission (published on 25 February 2014), which with certain extensions forms the base scenario for the 2014 EU-bank stress test, growth forecasts for the euro area have remained broadly unchanged even if near term projections are gradually edging downwards:
 

(Click to enlarge)

According to the 5 September news release by the Eurostat, relative to the same quarter of the previous year, seasonally adjusted GDP rose by 0.7% in the euro area. Despite that the second quarter was weak for the core (Germany and Italy registered a decline of 0.2% when compared to the first quarter, and France as well as the euro area as a whole stalled) and growth recovery is losing momentum, we still seem to be living in what might be called “stable disequilibrium”. As well summarized in the foreword to BIS’ 84th Annual Report, 2013/2014 (published in 29 June 2014):


“The global economy has shown encouraging signs over the past year but it has not shaken off its post-crisis malaise. Despite an aggressive and broad-based search for yield, with volatility and credit spreads sinking towards historical lows, and unusually accommodative monetary conditions, investment remains weak. Debt, both private and public, continues to rise while productivity growth has extended further its long-term downward trend. There is even talk of secular stagnation…”


In short, the illusion of stability persists thanks to the ultra-easy monetary policies which have proven less and less effective when it comes to reviving real economy. Now the ECB has not had any other choice but to announce a complex package of “money printing” measures that will have sizable impact on its balance sheet, incl. purchase of a fairly wide range of asset-backed securities (ABS). How long can this “money game” continue? How crazy can it get? For the starters, Irish two-year bond yields turned negative as a response to the 4 September cut of the euro area key interest rate and the signaled “aid” of at least 700 billion euros.

The hope is that it can continue as long as needed, that besides the ECB’s intended asset purchases, low interest rate environment increasingly forces investors (such as private-equity firms and other funds that pool money from pension plans and endowments) into buying junk from banks (and sharing losses from the so-called legacy assets, but this is later, some day when monetary policy is going to be “normalized”, assuming that there will be such a day). This way banks’ balance sheets could be cleaned, debt burden of the non-financial sector reduced and credit-based growth restored. A bleak outlook, but it’s unlikely that better solutions can be proposed on the same level of thinking where the problem was created.

What would happen if confidence to the central banks’ ability to somehow handle the situation (whatever it takes, just recalling Mr. Draghi’s remarks) were lost? This would be a true stress scenario – unlikely but possible (or maybe not so unlikely any more as the ECB’s 4 September decision on interest rate cut was perceived as unexpected and even hasty, see Q&A session of the press conference). It may just take a wrong monetary policy move by the Fed, an unexpected outcome of this very same ECB’s Comprehensive Assessment, or something going wrong with the fine plans of the Chinese authorities, or a mistake in geopolitics. A downward spiral (or call it vicious cycle or race to the bottom, whatever you might like) would be triggered and no one knows where the bottom is.
   
But neither the EBA nor the ECB is tasked with being the doomsday sayer. Their mission is to (re)build confidence in the system, even if some less important banks had to be wound down as “scapegoats”. As the rhetoric goes:
“The baseline and adverse scenarios are extremely realistic, and – together with the other procedures envisaged – ensure the reliability of the exercise.”
(Danièle Nouy, Chair of the Supervisory Board of the Single Supervisory Mechanism, in a recent interview with Äripäev)

The so-called realistic adverse scenario is based on the following four systemic risks:
(i) an increase in global bond yields amplified by an abrupt reversal in risk assessment, especially towards emerging market economies, and pockets of market liquidity;
(ii) a further deterioration of credit quality in countries with feeble demand, with weak fundamentals and still vulnerable banking sectors;
(iii) stalling policy reforms jeopardising confidence in the sustainability of public finances; and
(iv) the lack of necessary bank balance sheet repair to maintain affordable market funding.

Note that there is even no mention of geopolitical tensions which definitely were present already in April and have escalated ever since (Russia/Ukraine, Middle East). Despite of this one obvious omission, the narrative of the adverse scenario sounds pretty harsh, including expressions like:
* Shocks – repeated 50+ times in various combinations, incl. global financial shocks, demand shocks, supply shocks, house price shocks, sovereign bond spread shocks, shocks to borrowing costs for households and corporate, shocks to confidence;
* Ensuing financial turmoil;
* Currency depreciations in CEEs;
* Sizeable negative impact on real economic activity worldwide.
Monetary policy is (was, as it has already become more ee-mmm... accommodative than was expected back in spring) assumed to remain identical to the baseline level, i.e. accommodative but not that aggressive as it by now is in Europe.

According to the scenario, adverse developments are triggered from a rise in investor aversion to long-term fixed income securities (starting from the rising US long-term interest rates, i.e. implicitly assumed to be driven by the Fed’s moves) which results in a generalised re-pricing of assets and related selloffs.

In certain crucial respects, quantifications of the market risk scenarios look fairly modest. For example:

* The relative position of the adverse sovereign bond yield between the historical minimum and maximum since January 2000 is assumed to be just 43% for the euro area as a whole, this at the time when sovereign debt burden is at historic high both in absolute terms and as a percentage of GDP.

* Projected volatilities in market prices (interest rates, Fx, equities) are comparable or even low in historic perspective. This at the time when global financial markets under the spell of monetary policy and every shift in the policy outlook of major advanced economies leads to bout of turbulence (as e.g. implied by the bond market sell-off in May–June 2013 that reverberated around the globe). In other words, the assumption of stable monetary policy and retained market confidence toward central banks in an adverse scenario are in itself way too optimistic given that central banks are on uncharted territory.

* Adverse scenario impact to residential property prices ranges from -8% (Estonia) to -34% (Romania) compared to the baseline level in 2016. While this might be a realistic projection for the countries that have recently experienced substantial deflation in house prices, for certain others such as Sweden one might expect a shock almost twice as big as suggested. (For a reference, take a look to the Swedish real estate price index and households’ indebtedness. The country is not in euro area, but banking systems are closely connected.)

Over the past few years, the mantra in financial market has been “Don’t fight the Fed.” Now when the ECB is taking over the role of the Fed as the global liquidity provider, it may become “Don’t fight the ECB...” If the original adverse scenario assumption of unchanging monetary policy held, a technical analyst could have easily predicted a 50-60% decline in equity prices... But the assumption has not hold. In this light, the market risk scenarios look highly theoretical, not to say nonsense.

Anyways, following the description of various financial shocks and stresses, the narrative continues:
“The estimated negative impact of the various financial and real shocks on economic activity worldwide is substantial.”

I do not quite see where the referred substantial impact is.

When compared to the 2013 level, a cumulative GDP decline of 2.1% is foreseen (a decline of 0.7% in 2014, 1.4% in 2015 and 0.0% in 2016; on cumulative basis: 1*(1-0.7%)*(1-1.4%)*(1-0.0%)). In nominal terms, 2013 GDP for the euro area (18 countries, incl. Lithuania) was 9.6 trillion euros; thus -2.1% translates into 201 billion euros. Well, euro area GDP in 2009 vs 2008 was actually lower by 326 billion euros... A decline of 2.1% would mean going back to the year 2011 which was way above 2009. Note, however, that in the adverse scenario description, negative response of GDP is expressed in relation to the base scenario (cumulative decline of 6-7% by the end of the scenario horizon in 2016) which creates an illusion of severity as the baseline projection itself assumes growth.

As regards HICP inflation, then actual inflation rate is already below the level projected for the adverse scenario. Namely, the implied adverse inflation rates in the euro area amount to 1.0% in 2014, 0.6% in 2015 and 0.3% in 2016. According to the Eurostat’s flash estimate - August 2014, euro area annual inflation is down to 0.3%. So deflation is a very real risk (quoting Mario Draghi: “The point from a central banker’s viewpoint is that it's very difficult for us to reach the objective of an inflation rate which is below, but close to, 2% only based on monetary policy.”) and a number of countries are already recording declining prices. Does this matter? In the above referred interview, Danièle Nouy said that deflation was not an important part of the scenarios. Maybe it wasn’t for some reason, but deflation, or even a period of very low inflation, definitely adds to the problems of sluggish growth by raising real levels of debt and by (further) delaying spending and investment decisions.

...

Stress testing the whole banking system is a tricky task for the EBA and the ECB, especially if final conclusions about the major banks (that account for almost 85 per cent of total banking assets in the euro area) are ultimate responsibility of the ECB, an institution that at the same time is responsible for the euro area financial stability and is also conducting monetary policy. It becomes even trickier if we think about the over indebtedness of the non-financial sector and financial markets being under the spell of monetary policy. One doesn’t need to be a banking genius to conclude what the options are. On the other hand, one does need to be a banking genius to come out clean.

No comments:

Post a Comment